Industry Attractiveness Tool

Industry Attractiveness Tool

It is vital to understand the underlying competitive factors in the industry sector in which your company operates. You need a clear understanding of the attractiveness of your industry and your company’s position within this industry.

A detailed industry analysis is a massive task, taking many months to complete.For your industry, you need to judge the level of detail required. There are a wide range of groups that provide an information source:

From this information, you can begin to look at industry attractiveness. A number of standard attractiveness criteria can be used to determine general industry attractiveness. The criteria that I use are as follows:

It is almost impossible to find an industry that has high positive attractiveness in every one of these areas, but an analysis of each area will give you a balanced view of the attractiveness of your industry. The analysis will also help you in defining strategies to manage any less attractive components of your industry. I will now take you through the thought processes to assess your industry with respect to these criteria.

Growth

Growth potential is not just about individual products or services. It is about understanding the factors that drive demand for your range of products or services, that is your product sector or service sector. Understanding these factors will allow you to determine the growth potential of your business. You will need to understand the typical consumers of your products or services and any factors that influence a growth or reduction of consumers. Some typical factors could be the following:

• Demographic trends• Social trends• Technology trends

Demographic trends refer to changes in age profiles, sex, geographic movements, etc. For example, if people above fifty-five mainly use your services, then your growth potential is probably high, given that the percentage of people above fifty-five continues to increase every year. You are part of a growing industry.

Social trends refer to changes in the mix of work and leisure or changes in the typical activities people perform in their lives. For example, if your business is primarily concerned with selling prepared meals, then your growth potential is probably high, given the increasing trend towards buying these products. You again are part of a growing industry.

Technology trends in this context refer to the introduction of new mass technology that allows people to conduct activities that were otherwise technically impossible or too expensive. For example, if your business is directly related to the number of personal computers, or the number of Internet connections, then your growth potential is probably high, given the increasing mass availability of this technology. You again are part of a growing industry.

From an attractiveness point of view, industries whose future growth predictions exceed average gross domestic product (GDP) growth are obviously the winners. A simple categorisation of growth can just be the following:

Industry size is an important criterion. Once an industry reaches substantial size, it allows a diversity of competition. It encourages supermarket style, base product companies, technical innovators, geographic-based companies and single product companies all to participate in the market. This provides wider customer choice and different strategy options for companies.

The actual size in revenue an industry needs to reach to have the right critical mass to promote diversity of competition will depend on the capital intensity of the industry. The lower the capital required to enter an industry, the lower the revenue base required for an individual company. A good example of appropriate industry size is a comparison of the fast-food industry to a capital intensive manufacturing industry. A prospective owner looking at a fast-food business, with a relatively low capital input, would need to only consider the demand and revenue base from their local suburb. A prospective owner of a capital intensive manufacturing business would need to consider national and perhaps international requirements for their products to ensure they can develop a high enough revenue base. A simple categorisation of size can just be

• below target or• above target (the size at a critical level for a competitor to enter)

Profitability/Returns

Fundamentally attractive industries are those where the average return on funds employed (ROFE) is greater than the average cost of funds. The bigger the difference, the more attractive an industry is. In these industries, wealth is being created. Of course, risk and return are related, and the higher the return, the greater the risk. To calculate ROFE, simply divide earnings before interest and tax (EBIT) by total funds employed and multiply by hundred to make a percentage.

Unfortunately, an analysis of the last ten years of a number of mature manufacturing industries would show the average ROFE at less than the average cost of funds. These industries have not been attractive. It does not mean that the particular companies at the top of the industry cannot earn acceptable returns, but it does mean that a lot of companies are not earning acceptable returns.

Over the last decade, we would discover that a lot of service industries would have attractive returns significantly above their cost of funds. If we examined recent figures for some new high technology or Internet-based businesses, we might find unattractive returns. For these industries, we would need to make a judgement about their future attractiveness over the next decade as their market grows significantly. A simple categorisation of profitability can just be the following:

• Low (below average cost of funds)• Medium (at or slightly above average cost of funds) or• High (obviously above average cost of funds)

Competitive Structure

Understanding industry competitive structure is a fundamental part of strategic analysis. There are key structural features of industries that determine the strength of competitive forces and hence industry profitability. There are three fundamental areas that influence the competitive structure of your industry. They relate to the level of aggression displayed by your existing competitors, the potential for new competitors and the influence up and down your supply chain. The following diagram illustrates the forces driving industry competition.

I will now explain these three competitive forces in detail.

New Competitors Influence

New entrants to an industry, either with the same product or a substitute technology, can have the effect of lowering prices and increasing average costs, therefore reducing profitability. The threat of entry is low if there are enough barriers to entry in place. It can be difficult for new competitors to enter if

• you run a higher volume business with low costs,• you have loyal customers who value your product range,• it takes a large amount of capital to enter your industry,•it costs your customers a lot of money to change suppliers,• there is no easy channel for them to get their product to market,• there are government restrictions such as licensing.

Behaviour among Existing Competitors

Rivalry among competitors comes from perceived pressure or perceived opportunity. If rivalry is too intense, then all companies in the industry will be worse off in terms of profitability. Rivalry can be intense if

• competitors are about the same size,• the industry is not growing,• it is hard to exit the industry,• products are basically commodities,• competitors have high fixed costs.

The factors that determine the intensity of competitive rivalry do change over time. Once you understand the factors influencing rivalry in your industry, you can ensure that your strategies optimise your position. For example, you might make it harder for your customers to leave through technology, or you might direct your business towards the growing segments of the market.

Supply Chain Influence

Customers have an impact on industry profitability by pushing for lower prices and higher quality or more service. Customers have influence if

• there are a small number of them relative to the sellers,•the products are commodities,• it is easy to change suppliers,• they can backward integrate.

Suppliers have an impact on industry profitability by pushing for higher prices or lower quality of goods and services. Suppliers have influence if

• there are a small number of them relative to the customers,• there are no substitute products,• the industry is not an important customer base,• their product is vital to your business,• it is hard to change suppliers,• they can forward integrate.

Again supplier influence can change over time with industry structure and technology, and it is an important area of strategy formulation. This section on competitive structure has identified many factors that can potentially influence industry competition. Not all factors will be relevant in any one industry. For your industry, it could be that only a few factors are relevant. What has been provided for you is a sensible framework to help you identify structural features determining the nature of competition in your industry.A final overview of competitive structure can allow you to broadly categorise it as follows:

• Weak• Medium or• Strong

The weak competitive environment would have a low rating on the three areas of competitive influence. The strong competitive environment would have a high rating on most areas. No industry will be void of competitive forces, but obviously, the weaker the competitive environment, the more attractive the industry.

Market Diversity

The more diverse the range of market segments covered by your industry’s products, the more attractive your industry is. An industry is open to significant risk if its fate rests with a single market segment. The attractiveness of market diversity comes from the fact that different segments will have different growth rates and different demand cycles. This can smooth out the demand for products and allow a more efficient use of resources.

For this factor, we can apply a simple rating of

• Low (less than three segments),• Medium (three to five segments) or• High (greater than five segments)

Cyclicability

Cyclicability, to some extent, is related to market diversity. The more extreme the cyclical nature of demand for an industry’s products, the less attractive the industry is. The cyclical nature of demand can make it very difficult to organise resources. This area can have a simple rating of

The severity of laws and demands on industry with respect to occupational health and safety and environmental compliance will only become harsher over the next few years. Industries are obviously more attractive if they have little risk in this area.

Manufacturing industries are particularly at risk from occupational health and safety and environmental factors. Excellent systems and expertise of staff can overcome these risks, and in some industries, a particular company with skills in this area can have a competitive advantage. For a new entrant, the need for these systems and skills can be a significant barrier to entry. This characteristic of industry attractiveness can have a simple rating of

• Low (very low risk of a major incident),• Medium (some risk of a major incident),• High (risk of a major incident every few years).

Now it is time to use all the discussion points mentioned above about industry attractiveness to gain an overview of a particular industry. The table below is a notional industry attractiveness summary for a business. It lists the factors for industry attractiveness. It then gives a rating for a notional industry. It also gives the ideal attractiveness rating for each factor. From this table, one can get a balanced view of the attractiveness of the industry. Although it doesn’t reach the ideal on every factor, the example industry is generally on the attractive side.

Community RiskLow Low No major risks(Are there major O H and S or environmental risks?)
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Key Conclusions

The industry is moderately attractive, but niche firms with unique characteristics could enjoy high returns.